Wednesday, October 29, 2008

Red vs Blue

The ongoing financial crises demonstrates that the current banking system, as well as the theoretical frameworks in academic macroeconomics and finance, are unsound. One could even say bogus. The failure of these established modes of thinking has opened the door to new modes of thinking, one of which may be right, and the rest of which may be wrong. That's if we get lucky--all of them may be wrong.

I've linked to Mosler in the past, but it's worth rereading his primer on fiat money economics, and scanning through his ppt on the current crises (here). Of the many provocative things he says, here are a few of my favorite:

- The current downturn was caused by the reduction in the Federal deficit in the Clinton administration
- The best way out of the current downturn is to (temporarily) eliminate FICA taxes, and so increase the Federal deficit while transferring money directly to consumers
- The Euro will totally fail as the spending caps mean EU countries cannot run sufficiently high deficits to support aggregate demand in the face of negative consumer demand shocks
- The point of taxes is to get people to work (so they can earn $ to pay that tax and net save). Unemployment is high because taxes are low.
- Government spending comes from borrowing. It does not come from taxes. Taxes only exist to create demand for currency, and thus reduce unemployment.
- Countries that run current account deficits are king. Countries that run current account surpluses will lose.
- Deficits don't matter.

Remember, Mosler talks about fiat vs real currency. Fiat currency gives the Government options that real currency does not. In this other article, Mencius Moldbug lays out Bagehotian vs Misean banking systems. Bagehotian system maturity transforms (borrows short term money to lend long term money) while a Misean banking system does not. While Miseans are often conflated with hard currency advocates, please note that maturity transformation can happen (or not) with hard and fiat currencies alike. While Mosler and Moldbug are miles apart on many issues, neither of them likes MT.

Someone who disagrees about the importance of MT is Michael S., who has a number of excellent comments in Moldbug's post. His central claim is that banks "pay a great deal of attention to the duration both of loans and of deposits and apply sophisticated methods of analysis to balance them". Empirics would suggest that the amount of attention is insufficient, as is the sophistication of analysis, and the quality of balance. Nevertheless, he tells a story of bad regulation, poor decisions by the Fed, leverage, and bank capital.

My feeling is that he is incorrect. A pure "tally" bank, a bank that is simply a ledger matching borrowers with lenders (and matching maturity) can operate on zero reserves and never have a problem. It's "equity" is not a cushion against bank shocks, it's simply the present value of the expected future cash flow it gets from whatever fees it charges for matching borrowers and lenders. The left and right side of the balance sheet increase and decrease together, you don't get a sudden fall in assets which then need to be matched by a sudden fall in the equities side of the liability column. Assets are matched directly to liabilities, with equity simply being the profitability of the rest balance sheet.

I also feel that Michael S remains too focused on the proximate cause of proximate problems (the underlying loans were bad, so mortgage backed securities feel dramatically in value) and ignores the actual problem at hand (why have bad condo loans in Florida and California caused emerging market equity markets to tank 50%, push oil up 50% and then have it crash back down, cause Iceland to go bankrupt, cause the commercial paper market to freeze etc. etc. etc.) There is a difference between asset bubbles (where the value of the security gets unmoored from fundamentals) and a credit crises (where all credit instruments freeze up together) and the mechanism for contagion is the key to understanding the current situation. I have yet to find a better explanation than MT -- and if Mosler and Moldbug agree on something, it's worth thinking about.


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